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The Truth About Debt: The Good, the Bad, and the Ugly
Debt has earned a nasty reputation over the last few years. Foreclosures, bankruptcies and a growing national deficit have made honest citizens run for cover rather than risk getting tangled up with borrowed money. But debt is a tool. Like a gun for hire in an old western movie, debt can be a necessary means of achieving goals that would otherwise be out of reach. The trick is to differentiate between the good and the bad and to keep both from getting ugly.
Taking Aim at Your Goals
Typically, debt is considered good if it creates value. "Most people think of buying a home and financing their education as examples of good debt," says Diane Boyer, Budget and Credit Team Leader, Affinity Federal Credit Union. "Both are investments that may increase your wealth in the long run." If you're paying rent, exchanging your lease for a mortgage can be a smart choice. You're still paying for the roof over your head, but a mortgage often offers tax advantages.1 And the value of the home may appreciate over time. "Even if the home's value isn't going up right now, you may still build equity as you pay the mortgage, and that helps build your assets," Diane says.
When Debt Has You Cornered
"High debt makes people feel helpless," says Diane. "But taking control of your financial situation is really a matter of a few simple steps."
- Determine your expenses. For one month, track everything you spend, from the dollar for a vending machine snack to the minimum monthly payment on your credit card bills.
- Compare your monthly expenses to your monthly income. If you're in the red, seeing it in black and white can be a good dose of reality.
- Put away most of your credit cards, choosing the one with the lowest interest rate as your emergency-only card.
- Determine where you can cut expenses or how you can earn extra money, so you'll have more money to put toward paying off your debt.
- Rank your debts in order of highest to lowest interest rate and begin paying extra on the debt at the top of the list while paying the minimum on all of the others.
Education can offer similar advantages. "Often, the more education a person has, the more he or she can earn over a lifetime," Diane explains. Consider that in 2008, 25- to 34-year-old adults with bachelor's degrees earned 53% more than their peers with high school diplomas.2 Even in today's tough job market, college graduates are faring better than their counterparts without college education. According to the Bureau of Labor Statistics' unemployment numbers for May 2011, adults with a bachelor's degree or higher had an unemployment rate of 4.5%; the rate for adults with no college education was 9.5%.3 "Borrowing money to increase your earning power is usually a sound investment," Diane agrees.
Beware of the Recoil
Like the kick of a gun, bad debt has a way of recoiling painfully against the borrower. Generally, bad debt refers to money borrowed to purchase disposable goods or other products that lose value. "If you're paying interest on something that's losing value as you pay it off, that's usually considered bad debt," Diane explains.
With their high interest rates, credit card debts often add up to bad debt. "With credit cards it's so easy to spend more than you can afford. People don't realize how quickly the interest can add up," Diane says. For example, if you charge a $1,000 computer to a credit card with an 18.9% interest rate, you'll pay a total of $1,511 over the course of six years if you make minimum payments. Meanwhile, the computer will have depreciated to a value of $200 in half that amount of time.4
Beyond Black and White
Unlike gunslingers in a western, good and bad debt aren't always distinguishable by the color of their hats. Debt that is conventionally considered "good" can leave you hog-tied and helpless to meet the demands of mounting bills. A mortgage, for example, may build wealth, but homeownership also means paying property taxes and footing the bill for home repairs, routine maintenance and homeowners' insurance.
Conversely, what is frowned upon as bad debt may be the means of increasing your earnings. That $1,000 computer you charged becomes a savvy business investment if it enables you to pursue a career in freelance graphic design. "Unfortunately, there are no easy answers when it comes to debt," Diane says. "It all comes down to doing the math." A good rule of thumb - and the standard typically followed by financial institutions to determine a potential borrower's creditworthiness - is that your monthly debt payments, including mortgage and credit cards, should not exceed 36% of your gross monthly income.
Avoid the Ugly
All debt, regardless of its initial purpose, becomes ugly if you can't pay it off. "It's so important to have a clear understanding of where you stand financially," Diane urges. Affinity offers several services and products that can help you get a clearer view of your financial outlook.1 Please note that neither this financial institution nor any of its affiliates give tax or legal advice. Consult your tax advisor regarding your individual circumstances.
2 Source: National Center for Education Statistics.
3 Source: Bureau of Labor Statistics, Table A-4: Employment status of civilian population 25 years and over by educational attainment.
4 Source: U.S. General Services Administration Depreciation Guide.
Securities and investment advisory services offered by Affinity Investment Services, LLC, 73 Mountain View Boulevard, Basking Ridge, NJ 07920, member FINRA/SIPC. Investments offered by Affinity Investment Services are not deposits or obligations of Affinity Federal Credit Union. They are NOT NCUA INSURED and NOT GUARANTEED by Affinity Federal Credit Union or any governmental agency and are subject to INVESTMENT RISK, including LOSS of PRINCIPAL. Investments may lose value. Affinity Investment Services, LLC is a wholly owned subsidiary of Affinity Federal Credit Union. Business Continuity Disclosure Statement.
